Monday, January 30, 2012

What do you do when flood waters threaten the dam? If you're the Federal Reserve, you close the floodgates and let the water rise.

Metaphors have an uncanny ability to capture the essence of complex situations. Here is one dam metaphor that distills and explains the entire global financial system in 2012. The way to visualize the current situation is to imagine a dam holding back rising storm waters.

The dam is the regulatory system, the rule of law, trust in the transparency and fairness of the system and the machinery of perception management. All of these work to keep risk, fraud and excesses of speculation and leverage from unleashing a destructive wave of financial instability on the real economy below.

As legitimate regulation and transparency have been replaced with simulacra and manipulated data, the dam's internal strength has been seriously weakened.

Depending on how you date various rivers of financialization, water has been piling up behind the dam since either 1982, 1992 or 2000. In this metaphor, the water is comprised of multiple sources of destabilization: rising money supply, debt, speculation, leverage, fraud, shadow banking and lax regulation.

Common sense suggests that water rising to dangerous levels would trigger an official response of opening the floodgates to relieve the pressure. Unfortunately for the real economy, common sense has nothing to do with the official response of central governments and banks. Their entire raison d'etre (reason to be) is self-preservation and the preservation of the financial Elites that set the context and policy of the State and central bank.

In effect, the State and central bank recognize that it is highly dangerous to let any water out, lest the toxic waste of fraud, speculative incentives, excessive leverage, etc. corrode the spillway and cause the entire dam to give way.

The official rationalization for keeping the gates closed even as the water is rising to the very lip of the dam is that the flood water released might harm the real economy downstream.

The truth is less savory: letting any water out might reveal the vulnerability of the entire system to collapse and the complicity of the official State agencies and central bank in the decades-long process of piling up too much debt, leverage, fraud and speculation in the first place.

To avoid the exposure of their own complicity and incompetence, the officials would rather risk systemic collapse of the dam. The global exercise of masking the true risks in the system can be summarized as "extend and pretend," and for the the past four years, officials have promised that closing the floodgates and keeping all the toxic debt, leverage and fraud safely behind the dam is the "solution" to rising floodwaters.

That "solution" was temporary, and 2012 is the year that the water reaches the lip of the dam and starts spilling over. The only question for those in the real economy downstream is whether this spillage will be enough to relieve the mounting pressure or whether the dam will suddenly give way.

If the rivers of toxic debt, leverage and fraud continue flowing into the system, then the only way to relieve the pressure is to release more of the debt, leverage, risk and fraud than is entering the system. "Extend and pretend" does nothing to limit the inflow of toxic debt, leverage, fraud, etc., nor does it release any bad debt or shut down the sources of toxic flodwaters, i.e the shadow banking system and the Financial Elite perpetrators of fraud.

Will the dam of extend and pretend hold another year? Perhaps, but I suspect the toxic waters have corroded the spillways of trust and resiliency to the point that any official attempt to relieve the pressure will trigger the dam's collapse.

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